In economics, innovation is the introduction of a new or significantly improved product, service, production process, business method or form of organization into practical use. It is different from invention: an invention is a new idea or prototype, while an innovation is that idea brought to market or put to work. The OECD and Eurostat Oslo Manual (fourth edition, 2018), the international guide for innovation surveys, defines a business innovation as a new or improved product or business process that differs significantly from the firm's previous ones and has been introduced on the market or brought into use.
Economists see innovation as the main engine of long-run productivity growth and rising living standards. It draws on research and development, is protected in part by intellectual property rights, and is usually carried out by entrepreneurs and firms rather than by scientists alone. It is tracked through R&D spending, patents, business surveys and composite indicators such as the World Intellectual Property Organization's Global Innovation Index.
Innovation in plain terms
A cook who dreams up a new recipe has made an invention. The restaurant that adds it to the menu, works out how to make it quickly and sells it to diners has made an innovation. The second step is where the money and most of the risk lie.
Most innovation is modest: a quicker checkout, a cheaper part, a clearer bill. Every so often a change is big enough to reshape whole industries. Both kinds matter, because thousands of small improvements add up to large gains over time.
Types of innovation
- Product innovation. A new or improved good or service, such as a smartphone or a new insurance policy.
- Process innovation. A better way to make or deliver something, such as the assembly line or automated warehouse picking.
- Business-model and organizational innovation. New ways of earning money or organizing work, such as subscriptions or just-in-time manufacturing.
- Incremental and radical innovation. Small steps on an existing path versus breaks that open new markets. Clayton Christensen's The Innovator's Dilemma (1997) described "disruptive" innovations that start cheap and simple at the low end and later displace leaders.
- Frugal innovation. Low-cost solutions built for poorer markets. Kenya's M-Pesa, launched in 2007, showed how mobile money could deliver basic payments to people without bank accounts.
- Financial innovation. New instruments and channels, from ATMs to securitization and fintech.
Why markets may underinvest in innovation
Knowledge behaves partly like a public good: one firm's use of an idea does not stop others using it, and ideas are hard to keep secret. When rivals copy, the innovator bears the cost while others share the benefit, a positive externality. Kenneth Arrow set out this argument in 1962, and later studies have estimated that the social returns to R&D are well above the private returns earned by the firms that pay for it. Innovation also involves deep uncertainty and asymmetric information between inventors and lenders, which makes bank lending difficult and helps explain the role of venture capital.
These features make innovation a classic case of market failure. Governments respond with patents and copyrights, which grant temporary exclusive rights; R&D tax credits and grants; public research in universities and laboratories; prizes; and public purchasing of new technologies.
Measuring innovation
No single number captures innovation. Inputs such as R&D spending and research staff are easy to count but say nothing about results. Patent counts measure some outputs but vary widely by industry. Surveys based on the Oslo Manual, including the European Union's Community Innovation Survey, ask firms directly whether they introduced new products or processes. At the national level, economists treat growth in total factor productivity as an indirect sign of innovation.
WIPO's Global Innovation Index 2025, published in September 2025, ranked Switzerland first for the fifteenth year running, followed by Sweden, the United States, South Korea and Singapore. China entered the top ten for the first time, the only middle-income economy there.
Innovation, competition and policy
Economists have long argued over whether big firms or competitive markets innovate more. Schumpeter stressed that the hope of monopoly profit drives invention and that large firms can fund research. Arrow argued that a monopolist has less reason to innovate because it would mostly replace its own profits. Later research finds that the answer depends on how close rivals are, and links the debate to creative destruction and competition policy.
Policy tools include industrial policy, support for business clusters and, in finance, regulatory sandboxes that let new firms test products under supervision. Critics warn that patents can block follow-on work, that subsidies may reward projects that would have happened anyway, and that some financial innovation, such as complex mortgage securities before the 2008 financial crisis, can add risk rather than value.